Macroeconomics subject For undergraduate students (semester 2)

1. Economic fluctuations and
AD-AS model
Meeting 1

2. INDIKATOR
• 1. menjelaskan fluktuasi ekonomi dan karakteristiknya
• 2. bagaimana agregate demand dan agregate supply mampu menjelaskan
fluktuasi ekonomi.
• 3. menjelaskan bagaimana bentuk slope agregate supply dalam jangka
pendek dan panjang
• 1. explaining economic fluctuations and their characteristics
• 2. how aggregate demand and aggregate supply explain economic
fluctuations.
• 3. the shape of the slope of aggregate supply in the short and long term

3. Economic fluctuations
• Fluctuations in the economy are often called the business cycle
• Short-run (2-3 years)
• Long-run
• They are all unpredictable
• When the recessions occur GDP falls, unemployment rises
• Recession: a period of declining real incomes and rising unemployment
• Depression: a severe recession
• Expansion: a period of increasing real incomes, and falling unemployment

4. Economic fluctuations are irregular and
unpredictable
• Recessions start at the peak of a business cycle and
end at the trough.
• The length of a business cycle may be measured by the
time between one peak and the next or the time
between one trough and the next.
• The peaks and troughs of the US business cycle are officially
registered by the NBER.
• During 1945-2009, there have been 11 cycles in the US.
• The average recession lasted 11 months and the average
expansion lasted 59 months, thereby making the average
cycle roughly 70 months long.

5. Business Cycle

6. Recession vs Depression
RECESSION DEPRESSION
Oil recession of 1973-1975
2001 Recession (after 11 September)
Great Recession aka The global economic recession of
2007-2009
Oil recession 2014-present
Great Depression in USA 1929-1933s
• When your neighbour loses their job, it’s a recession
• When you lose your job, that’s a depression

7. Recession vs Depression
BASIS FOR COMPARISON RECESSION DEPRESSION
Meaning
Recession is defined as a period
when there is a downfall in the
economic activity of the country,
resulting in the fall in the country's
GDP.
The situation when there is
sustained and drastic recession in
the economy, it is known as
depression.
What is it? Cause Effect
Criterion
Negative GDP for two successive
quarters
10% or more decrease in real GDP
Occurrence Frequent Rare
Strikes
Different countries at different
times.
World economy as a whole.
Effect Severe
More severe and may continue for
a long time
Unemployment Rate Low High

8. Short-run vs Long run
• In the long run: nominal variables such as the money supply and the
price level do not influence real variables such as output and
employment
• In the short-run: economic fluctuations are analysed using the AD-AS
model, the output of goods and services and the overall level of
prices adjust to balance aggregate demand and aggregate supply

9. Short-run vs Long run
•In the short-term nominal values (prices, wages, nominal
interest rate) change slowly (fixed or constant)
• Real values (output, employment rate, real interest rate) more
flexible
•In the long-term, on the contrary, nominal values are flexible,
but the real values are constant

10. AD-AS
• To understand fluctuations of output and price levels
• To determine governmental economic policy

11. AD
• AD – market value of final goods and services produced in the
economy in a given time period
• In the absence of restriction by the production, and also in the
absence of strong inflation, the growth of AD stimulates an increase
in output and employment, providing little impact on the price level.
(Example: USA policy stimulating AD in 1930-s crisis)
• However:
• If the economy is close to full employment, the growth of AD will
cause not only an increase in output (as virtually all power is already
involved) as the rise in prices.

12. AD curve
• It shows the amount of goods and services that consumers are willing to buy at
each possible price level
• It shows such a combination of output and price level in economy, in which
commodity and money markets are in equilibrium
• Quantity theory of money (QTM):
• MY= PY, hence P=MV/Y or Y= MV/P
where
• P – price level in economy
• Y – real output in economy
• M – quantity of money in economy
• V – velocity of money
• The relationship between the volume of output (Y) and the price level in the
economy (P) is negative at a certain constant money supply (M).

13. AD curve: the negative slope
• Is due to the following:
• The higher the price level P, the lower the actual stocks of cash M
• AD curve is based on the condition of a fixed money supply M and
velocity of money V)
• Therefore, the less the amount of goods filed with that demand

14. AD curve: the negative slope
price factors:
1. The wealth effect (Pigou effect): a lower price level raises the real
value of households’ money holdings, which stimulates consumer
spending
2. The interest-rate effect (Keynes effect): a lower price level reduces
the quantity of money households demand; as households try to
convert money into interest-bearing assets, interest rates fall, which
stimulates investment spending
3. The exchange-rate effect (Mundell-Fleming effect): as a lower price
level reduces interest rates, the dollar depreciates in the market for
foreign-currency exchange, which stimulates net exports

15. AD curve: the negative slope
non-price factors
Figure 1. increasing Money Supply (or the Velocity) and a corresponding increase in
Demand in the economy will be reflected in the shift to the right
Figure 2. the decline in oil demand in the world market and the corresponding
decrease in export will be reflected in the shift to the left
Figure 1. Figure 2.

16. AD curve
non-price factors
• Any event or policy that raises consumption, investment, government
purchases, or net exports at a given price level increases AD
• Factors from GDP Equation (C+I+G+Xn)
• Consumption (C), Investment (I), Government Spending (G) and Net
Exports (X) - government can influence
• Any event or policy that reduces consumption, investment,
government purchases, or net exports at a given price level decreases
aggregate demand

17. AS
• The total amount of goods and services produced in the economy
• This concept is often used as a synonym of GDP
AS curve
• AS curve shows how much of the total output can be offered on the
market by different manufacturers under the different price values in
the economy.

18. AS curve shift
non-price factors
• Changes in technology, resource prices, corporate taxation etc., which
graphically reflects the shift of the AS curve
• A sharp rise in oil prices leads to increase of costs and reduces the
volume of supply in the economy, which shifts AS curve to the left
• High yield, caused by unexpectedly favourable weather conditions,
increases the volume of AS and shifts the AS curve to the right

19. AS curve: two approaches
Classic and Keynes
CLASSIC KEYNES
- Long term
- Markets are competitive
- Output depends only on factors of production (L, K,
T) not on prices
- Changes in factors of production and technology
occur slowly
- Economy is functioning in the conditions of full
employment
- Prices and nominal wage are flexible
- AS curve is vertical because of Labour Market
(Labour is the main Factor of Production)
- Short term
- Economy is functioning in the conditions of
underemployment of production factors
- Prices and nominal wages are fixed
- Real values are flexible
- AS curve is horizontal (fixed prices) because of the
duration of employment contracts and
governmental regulation of the minimum wage

20. AS curve: Classic model (long-term)
• ↑P → ↓Wr → Ld > Ls → ↑Wn → ↑Wr → Y const
• AS shifts only if factors of production or technology change, if they
don’t change LRAS is fixed on a potential output level Y*,
• and changes in AD are reflected only on Price levels
• Y depends on labour, capital and technology,
• So Y doesn’t depend on Price levels,
• that’s why it is vertical

21. AS curve: Keynes model (short-term)
• AS curve depends on AD
• In conditions of underemployment of factors of production and fixed
prices AD fluctuations cause firstly changes in Output volume and
only afterwards may affect price levels
• If the government wants to increase Output, it should stimulate AD
through fiscal and monetary policy, e.g:
• to increase government spending
• to cut taxes
• to expand the money supply

22. AS curve: Keynes model (short-term)
Government increases Output Central bank decreases Money Supply

23. AS curve: two approaches
Vertical (long-run) – Classic
Horizontal (short-run) - Keynesian

24. AS shock: stagflation
• Costs ↑ → Prices↑ → Y↓ (point B)
AS shock: government intervention
• Government stimulates AD (it helps
• But we have higher prices now)

25. AS shock: OPEC stagflation 1970-1980s
• In 70-s OPEC decided to reduce oil production → oil prices doubled
• That led to stagflation (stagnation + inflation) and unemployment
• Later OPEC again raised oil prices → second stagflation
YEARS OIL PRICE CHANGE INFLATION UNEMPLOYMENT

26. AS shock: OPEC stagflation 1970-1980s
• Later, there were some discrepancies among OPEC countries, so they
couldn’t rise oil prices anymore, and US economy stabilized
• In 1986 oil priced decreased twice

27. AD-AS macroeconomic equilibrium
• The intersection of AD and AS determines the equilibrium
of output and the price level in the economy
• As a result of the monetary supply growth AD increased
from AD1 to AD2, and a short-term equilibrium is
established at point B and the price level remained
unchanged
• Under the influence of the high level of Demand the
Output increases, but the products are still being sold at
old prices
• However costs start growing gradually: in the absence of
a sufficient resources and increasing demand on them,
their prices also grow, for example, wages
• This leads to a rise in prices for finished products. As a
result Demand starts to decrease and the economy
returns to the previous level of Output, but at a higher
price level
• The long-term equilibrium is established at the point S

28. Disequilibrium of AD-AS model
• 2 types of imbalance:
• Deficit – excess demand with a lack of supply (more typical for the
centrally controlled economy)
• Overproduction – excess supply with a low demand (typical for the
market economy)

29. AD and AS shocks
price shocks, oil shocks
• AS shock – sharp changes in prices
• AS shocks may be associated with a sharp change in prices for
resources (price shocks, such as oil shock), natural disasters, resulting
in the loss of part of the economy and a possible reduction in the
capacity of resources

30. Oil shock : government non-intervention
• Negative AS shock (rise in oil prices) causes
a rise in Price level and a shift of a short
term SRAS1 curve to SRAS2 and fall of
output till point B.
• If government and central bank don’t
interevent, economy will adjust itself:
• When the level of output and employment
are below potential (point B) prices will
gradually decline, and the level of
employment and output will return to its
previous position (backward motion to
point A). However it can be a very long
process.

31. Oil shock: government intervention
• The central bank can neutralise the
decline, increasing the money supply
(shift from AD1 to AD2), but the
consequence of this would be a
higher level of prices, as a result of
shock (point C). A similar result is
achieved by increasing governmental
spending.
• Thus, the economic policy of the state
is faced with a certain dilemma of
prolonged recession and
unemployment or rising prices, while
maintaining the level of employment
and output.